Managing your money in a tax-efficient manner is generally to be recommended at any stage in life, but it’s arguably most important for pensioners, who need to make the income they’ve earned during their working years, last them all of the rest of their days, literally. Over recent years, the government has permitted greater flexibility with regard to how people can manage their pension, however greater freedom brings with it a greater degree of responsibility for people to understand what their options are and what they mean in practical terms.
You have several options as to how to treat your pension pot when you reach retirement age
Option 1 - withdraw up to 25% of your pension pot as a tax-free lump sum and use the rest to buy an annuity. This was one of the only options prior to the world of pension freedoms and it may still be a very good option for some people. Annuities have the advantage of reliability and simplicity and in some cases these may be major selling points.
Option 2 - withdraw up to 25% of your pension pot as a tax-free lump sum and reinvest the rest to provide an income (known as income drawdown). This approach carries the usual risks and rewards of any form of investment and as such benefits from being well-managed.
Option 3 - withdraw cash lump sums on a regular basis, paying tax on 75% of each withdrawal. This keeps your pension pot in limbo, so to speak, in that you neither get the security of an annuity nor the potential returns offered by income drawdown.
Option 4 - withdraw the full pot as a lump sum and pay tax on 75% of it. This option is only likely to be recommended in a very small percentage of instances.
Option 5 - leave it be for the time being. You can simply leave your pension pot to grow until you have need or want to use it.
Pensions income is taxable but you still have a personal allowance
At current time (2017/2018 tax year), if your total income is less than £100K, the first £11.5K of your total income is tax free. The key word here is total income, in other words, if you have non-pension income, such as income from employment, then this will also count towards your taxable income. If you find you can live comfortably on less than your personal allowance, it may still be worth your while to withdraw extra income from your person, to make the most of your tax-free income allowance each year. If you earn £100K or more, then each £2 you earn reduces your personal allowance by £1, hence, if you earn 123K or more, then your personal allowance will be eliminated.
Other standard tax-free allowances still apply
You can still hold ISAs and take advantage of their tax effectiveness. For example, if you withdraw more income from your pension than you actually need in order to make the most of your personal allowance for income tax, you could find it useful to place the extra in an ISA (cash or any other form) to shield it from tax. If you want, or need, to hold funds outside of an ISA wrapper, there are further options available to you. At this point in time, you have a dividend allowance of £5K although this is due to reduce to £2K next (tax) year. Similarly you have a personal savings allowance of £1K (base rate tax payers) or £500 (higher-rate tax payers), meaning that you can earn interest on savings up to this amount without having to pay tax.
The value of pensions and investments and the income they produce can fall as well as rise. You may get back less than you invested.
Tax treatment varies according to individual circumstances and is subject to change.